Chapter 22, Problem 1CQ

Options What is a call option? A put option? Under what circumstances might you want to buy each? Which one has greater potential profit? Why?

Summary Introduction

To determine: The meaning of call option, put option, circumstances under which they might be bought and whether call option or put option has greater potential profit.

Option:

Option refers to the formal contract between the issuer and buyer that provides right to buy or right to sell and not the obligation for a specific property or a commodity at a specified time period.

Answer to Problem 1CQ

• A call option is which does not carry any obligation on the right given to an individual to ‘purchase’ an asset at any particular price fixed or given point of time.
• A put option is the option which does not carry any obligation on the right given to an individual to ‘sell’ an asset at a particular fixed price on given point of time.
• When an increase in the price of the underlying asset is projected then it would be beneficial to buy a call option and when a decrease in the underlying asset is expected then purchase of put option is beneficial.
• Greater potential profit can happened in either of the cases depending upon the increase or decrease in the value of the underlying asset.

Explanation of Solution

• The call option is the option that provides a right not an obligation to sell an underlying asset anytime before expiration. So, when the price of the asset is increased over the period the buyer can be benefited by selling the asset at her price and when it is deceased he can choose not to sell and continue with holding it.
• The put option is the option that provides a right not an obligation to buy an underlying asset anytime before expiration. Son, when the price of the asset is decreased over the period, the buyer can be benefited by purchasing the asset at lower cost.
• The call option and put option both have similar potential profit depending upon the change in the value of the underlying asset, greater increase in asset would increase the potential profit in call option and greater decrease in asset would increase the potential profit in put option.

Conclusion

Thus, the potential profit in call and put option depends upon the change in the price of the underlying asset.